Arizona Section 125 Cafeteria Plan Regulations

Arizona does not have its own regulations for Section 125 cafeteria plans. The state conforms to the federal rules by defining Arizona gross income as a resident’s federal adjusted gross income, so any dollar an employee routes through a cafeteria plan on a pre-tax basis is excluded from Arizona taxable wages automatically.¹ At Arizona’s flat 2.5% income tax rate, that conformity stacks on top of federal income tax savings and the 7.65% FICA savings on both sides of the payroll.² What Arizona employers and employees need to work with, then, is the federal Section 125 framework and the 2026 dollar limits that cap the tax benefit.

How Arizona Taxes Cafeteria Plan Contributions

Arizona’s connection to Section 125 runs through one statute. Under ARS 43-1001, Arizona gross income for a resident is the taxpayer’s federal adjusted gross income for the taxable year.¹ Because qualified Section 125 contributions are excluded from federal AGI before Arizona ever calculates its tax, those dollars never enter the state base. There is no add-back in ARS 43-1021 that would pull Section 125 money back in at the state level.³

The same conformity applies to payroll withholding. Arizona’s withholding statute keys off wages paid for services performed in the state,⁴ and the Arizona Department of Revenue uses the federal wage definition under 26 U.S.C. § 3401 to determine what counts.⁵ If pre-tax deductions are properly excluded from Box 1 of the W-2, Arizona withholding comes out right as a matter of math. Employers do not run a separate state calculation.

The practical result for an Arizona employee: every pre-tax dollar avoids federal income tax at whatever marginal rate applies, Arizona income tax at 2.5%, and 7.65% in Social Security and Medicare taxes. The employer saves the matching 7.65% on its side of payroll.

What a Section 125 Plan Is

A Section 125 cafeteria plan is a written employer arrangement that lets employees choose between taxable cash compensation and qualifying benefits paid for on a pre-tax basis. The plan must offer at least one taxable option and at least one tax-free qualified benefit, and it has to live in a formal written plan document that spells out eligibility, benefits, and how elections work.⁶ Only employees can participate.

Money redirected through the plan comes out of pay before taxes are calculated, which is why the wages reported to the IRS and to Arizona are reduced. The tradeoff is that elections are generally locked for the entire plan year. Employees pick during open enrollment and stay with those choices until the next enrollment, with limited exceptions discussed below.

2026 Contribution Limits by Benefit

Not every benefit can run through a cafeteria plan. The federal code limits qualified benefits to specific categories, each with its own cap.

Premium Only Plans

The simplest arrangement lets employees pay their share of group health, dental, and vision premiums with pre-tax dollars. There is no separate IRS dollar cap because the contribution is set by the actual cost of coverage. For many small Arizona employers this is the only Section 125 benefit offered, and it still produces meaningful savings for both sides of payroll.

Health Flexible Spending Accounts

A health FSA covers out-of-pocket medical costs like copays, deductibles, prescriptions, and dental work. For the 2026 plan year, the IRS caps employee salary reduction contributions at $3,400. Health FSAs are subject to use-it-or-lose-it, but a plan can soften that with either a grace period of up to two and a half months after the plan year ends or a carryover provision. For 2026, the maximum carryover into the following plan year is $680.⁷ A plan can offer one or the other, not both.

Dependent Care Assistance

Dependent care accounts fund daycare, after-school programs, and elder care expenses that let you and your spouse work. Starting with the 2026 tax year, the maximum annual contribution is $7,500, up from the longstanding $5,000 cap. Married individuals filing separately are limited to $3,750.⁸ There is no carryover. Unspent funds at year-end are forfeited.

Health Savings Account Contributions

Employees enrolled in a qualifying high-deductible health plan can make HSA contributions through a cafeteria plan on a pre-tax basis. For 2026 the limit is $4,400 for self-only coverage and $8,750 for family coverage.⁹ HSA funds roll over indefinitely and stay with the employee after they leave the job. Running HSA contributions through a cafeteria plan picks up the FICA savings that a direct individual contribution would not.

Changing Elections During the Plan Year

The default rule is that elections are irrevocable for the plan year. Federal regulations recognize specific events that permit a mid-year change:

Change in legal marital status: marriage, divorce, legal separation, annulment, or death of a spouse.
Change in number of dependents: birth, adoption, placement for adoption, or death of a dependent.
Change in employment status for the employee or a spouse, including starting or leaving a job, moving between full-time and part-time, or taking an unpaid leave.
Gaining or losing eligibility for Medicare or Medicaid.
A judgment or decree requiring health coverage for a child.
Significant cost or coverage changes under the plan, such as a substantial price increase or elimination of a coverage option.

The change must be consistent with the event; a new baby does not justify dropping dental coverage. One detail employers often miss: a cafeteria plan is not required to allow any of these changes. The plan document has to specifically list which events the employer recognizes.¹⁰ If the document is silent on an event, the employee is locked in regardless of the circumstances.

Nondiscrimination Testing

Section 125 plans cannot disproportionately favor highly compensated or key employees. Federal law requires three annual tests: eligibility (whether rank-and-file employees have the same access as higher-paid staff), contributions and benefits (whether the value skews toward the top), and a key employee concentration test (whether more than 25% of total plan benefits go to key employees).⁶

When a plan fails, the consequences land on the highly compensated and key employees only. Their pre-tax benefits are reclassified as taxable income, and the employer has to adjust withholding and W-2 reporting. Rank-and-file employees keep their tax-free treatment. Small Arizona companies with a handful of owner-employees and a few lower-paid workers can easily trip the concentration test if the owners elect rich benefits and most staff opts out.

The Simple Cafeteria Plan Alternative

Employers that averaged 100 or fewer employees in either of the two preceding years can adopt a “simple cafeteria plan” and skip nondiscrimination testing entirely. Once established, the employer stays eligible until headcount reaches 200.⁶

The safe harbor requires employer contributions for every non-highly-compensated eligible employee under one of two formulas: a nonelective contribution of at least 2% of each qualifying employee’s compensation, or a matching contribution equal to the lesser of 6% of compensation or double the employee’s own salary reduction. Highly compensated and key employees cannot receive a higher matching rate than other staff. In exchange, the plan is treated as passing the nondiscrimination tests for cafeteria plans, group-term life insurance, self-insured medical plans, and dependent care assistance. For Arizona businesses in the 20-to-100 employee range, the predictable contribution cost is often preferable to the annual compliance risk.

Employer Compliance Basics

Running a compliant Section 125 plan involves ongoing administrative work beyond the initial election. The core obligations:

A written plan document must exist before the first day of the plan year, describing eligible benefits, election procedures, contribution methods, and the plan year. Retroactive adoption is not permitted.⁶
An annual open enrollment period must be offered for employees to make or modify elections for the upcoming plan year.
Section 125 pre-tax deductions reduce taxable wages in Box 1 of Form W-2. There is no mandatory Box 12 code for Section 125 contributions themselves, though some employers label them in Box 14. Box 12 Code DD reports the total cost of employer-sponsored health coverage and is informational only.
The cafeteria plan wrapper itself does not require a Form 5500. Underlying benefit plans funded through it, such as a self-funded medical plan with 100 or more participants, may have their own ERISA filing obligations.

Because Arizona defines taxable wages by reference to the federal definition, getting the federal side right produces the correct Arizona withholding automatically.⁵

The Social Security Tradeoff

Pre-tax Section 125 contributions reduce wages for Social Security and Medicare tax purposes, which is where the 7.65% FICA savings comes from on both sides of the payroll. The flip side is that lower reported wages can reduce the Social Security benefits you eventually collect, because the Social Security Administration calculates your retirement benefit on your highest 35 years of earnings.

For most employees the immediate tax savings outweigh the future benefit reduction, particularly for workers already earning above the Social Security wage base ($176,100 in 2025). If earnings already exceed that cap, Section 125 deductions have no further effect on Social Security calculations. For lower-wage employees contributing heavily to an FSA or dependent care account, the long-term benefit impact is worth weighing against the current-year tax reduction.

1
Arizona Legislature. Arizona Code 43-1001 – Definitions
2
Arizona Department of Revenue. Individual Income Tax Highlights
3
Arizona Legislature. Arizona Code 43-1021 – Addition to Arizona Gross Income
4
Arizona Legislature. Arizona Code 43-401 – Withholding Tax; Rates
5
Arizona Department of Revenue. Arizona Withholding Tax
6
Office of the Law Revision Counsel. 26 USC 125 Cafeteria Plans
7
FSAFEDS. New 2026 Maximum Limit Updates
8
Office of the Law Revision Counsel. 26 USC 129 – Dependent Care Assistance Programs
9
Internal Revenue Service. Revenue Procedure 2025-19
10
eCFR. 26 CFR 1.125-4 – Permitted Election Changes